Opinion: What China’s ‘new normal’ means for commodities

HONG KONG (MarketWatch) — China’s “new normal” economy might suggest merely impressive growth, rather than the magical growth of recent decades. But for natural commodities and large swathes of the world economy, things may never be the same again.

In a new report, Citi argues that global economic growth is now undergoing a fundamental transition, with a shift away from the prevailing model of China as the world’s factory. In the previous decade, China hollowed out industry from just about every corner of the globe as it became the dominant manufacturer of everything from Apple
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iPhones to sneakers and furniture. At the same time, it also became the primary driver of global commodity demand, supporting a multiyear commodity super cycle.

But now, as commodities across the board continue to make fresh multiyear lows, it is clear this boom is over. Analysts are now grappling with the wider implications as the price declines stretch from weeks to months, forecasting an upheaval in industry structures, trade flows and commodity markets.

China’s weakening commodity demand looks to be structural and permanent. While recent strength in the U.S. dollar
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may have contributed to global commodity weakness, the slowdown in China is the dominant factor. This is not just a cyclical pause but an act of considered government policy to finally rebalance the Chinese economy, which even eight years ago then-premier Wen Jiabao described as “unstable, unbalanced, uncoordinated and unsustainable.”

Beijing now effectively has no other option but to steer a new course due to environmental damage, industrial overcapacity and dangerously high corporate debt levels caused by the excessive investment that went before. And there can be little doubt this will mean lower growth.

Citi calculates that to begin rebalancing and bring investment’s share of gross domestic product down to 40% from the current 50%, investment growth would need to be around four percentage points lower than GDP growth. Based on the current 7% economic growth target, this would mean 3% investment growth.

This change will have profound implications for commodity demand, given the exposure of most industrial commodities to China, says Citi.

Just as China’s growth lifted commodity-producing nations the world over, we can expect the reverse to also be true, with investment plans pulled and assets written down as prices fall. Macquarie Research writes that in the past few years, any available raw-material supply has tended to find a Chinese buyer, with China effectively acting as a global clearing-house.

This about-face will be polarizing for individual commodities, with those in oversupply — such as bulk commodities like coal, steel and iron ore — the biggest losers. Materials which China has less of, such as nickel and chrome, will do better.

For base metals, we need to look beyond China to assess the future. Citi argues that the commodity-price cycle has been reset, and we will now have to get used to a multipolar world. Instead of it all being about China, demand growth will increasingly come from the “Emerging Five,” namely India, Southeast Asia, the Middle East, Latin America and Africa.

Although these new sources of demand will pick up the baton, even collectively they cannot match the demand growth that China brought when it arrived on the world stage as an industrial power.

This new multipolar natural-resources economy will trigger changes beyond pricing. We will likely see a slowdown in trade flows, as commodity producers focus on developing their own domestic downstream industries. In the past, China imported raw materials and built its own smelting and refining capacity, helped by low costs and plentiful financing. Macquarie expects we will see a return to the practice where much of the value added to the extracted material gets added next near the mine it comes from. This change will mean less business for bulk shippers.

Within China, we can expect these new market forces to speed up rebalancing. Mining and smelting will come under pressure, particularly given that these sectors have some of the highest industry debt levels. High-yield bonds could be exposed as deflation undermines debt servicing. Macquarie expects that over the long term, banks will move capital upstream and into new economic sectors as they seek better returns.

While investors will welcome moves to put China’s economy on a more sustainable footing, they will also be cautious, as the transformation could be messy, and Chinese growth may well miss targets. Citi at least draws comfort from the fact that since the service sector is much more labor-intensive than heavy industry, the transition should be less painful in terms of employment.

One takeaway is to expect investors to focus more on China’s new economic growth opportunities and away from its smokestack heavy industry. Renewable and clean energy will continue to get official support.

Another is that, even beyond commodities, the global growth story will be less about just China. These shifts mean other emerging markets will have more of a chance to get investor attention and foreign investment flows.

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